Funds Are Dead, Long Live Funds

Reading your fund account statement these days feels a lot like going over your bike's handlebars on a steep gravel road. But one bad fall should make you change your style -- not quit.

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Big Screen Archive: Solid Funds and How They Fit Together

It's understandable if your patience with funds and well-coiffed fund managers is running a tad thin these days. After all, your stock funds are probably in the red and trailing bonds over the past three years. Heck, odds are they're barely beating them over the past five years. Losing money hurts and you might logically be asking yourself why you're paying someone to turn dollars into pennies.

If you are, you're not alone given the paltry inflows to funds this year. While it's natural to be underwhelmed and many funds and fund companies deserve our ire, it's a mistake to give up on all funds altogether. Here's why: If you do your homework and cobble together a diversified portfolio of solid funds, they're still the cheapest and most effective way for most of us to reach our goals over time.

"As much as a lot of investors are disgusted with funds, it's been bad all over," says Christine Benz, a senior fund analyst with Chicago research house Morningstar. "A lot of investors have been burned far worse by going with their own stock picks."

It's easy to see why folks are disappointed with the pros. A $10,000 investment spread evenly among the five top-selling funds in 2000 at the start of that year would've been worth less than $6,400 two years later. More than seven in 10 large-cap funds trailed the S&P 500 over the past five years and you find the same thing over the past 10 and 15 years, according to data through the end of 2001.

Fading FavesA $10,000 investment in 2000's top sellers would've been worth just $6,357.13 after two years

Sources: Financial Research Corp. and Morningstar. *Closed to new investors.

As the tech-stock bubble inflated, many fund companies seemed just as susceptible to the sector's siren song as their customers. As tech and tech-heavy funds began to dominate the sales charts in 1999 and 2000, fund companies slapped together tech funds as fast as they could. Now that the average tech fund sports a 12% annualized loss over the past three years, you might wonder if fund shops were guilty of making what sells, rather than simply selling what they make, to borrow a phrase from Vanguard founder Jack Bogle.

The Money ChaseFund companies tripled the number of tech funds as cash flows to the sector rose

Sources: Morningstar and Financial Research Corp.

The last straw: The "smart money" didn't see Enron's collapse coming. At the end of 2000, more than 1,400 stock funds had Enron in their portfolio. More than a third of the big-cap growth funds owned shares at that point.

With this in mind, there are four facts you should consider before giving up on funds and fund investing:

There Are Plenty of Good Funds Out There

While we have tossed a number of ill-conceived and poorly run funds into our Ima Loser Fund Club, we've also dug up true gems like the Oakmark fund run by Bill Nygren and Ritchie Freeman's Smith Barney Aggressive Growth fund. If you want to find more and learn how to screen out losers, just check our Big Screen archive.

Building a Diversified Portfolio Isn't Rocket Science

Part of being a savvy fund investor is finding great funds and managers, but if you don't shoehorn them with different types of funds into a diversified portfolio, you really haven't done the job. Just as a diversified portfolio will rise and fall with the market, one that is heavily weighted toward one sector or style will rise and fall in erratic bursts with that sector or style. Our Big Screen archive lays out a blueprint of a diversified portfolio of several funds, but we've also shown you how you can do the same with just two or three funds, or maybe even one.

Funds Are Cheap

Funds were designed to give us, nonmillionaire investors, cheap access to a professional manager and a broad portfolio of stocks. They still do that and it's still a big plus. While there are pricey funds out there, any screening tool lets you focus on those with more sensible price tags. Consider how much in trading fees it would cost to build a diversified portfolio of 100 or so stocks and then consider that the Vanguard 500 Index fund lets you track the S&P 500 for just a 0.18% annual expense ratio. That's just $18 for every $10,000 invested.

Depending on the size of your portfolio and how much trading you do, you might be able to build a cheaper, more diversified portfolio. But most of us simply couldn't.

Investing Isn't Easy

When I posted an interview with a portfolio manager in 1999 and early 2000, I'd routinely get a slew of email from readers touting their own picks and returns. That doesn't happen anymore, mainly because many of those folks have lost their shirts.

Consider that even Microsoft ( MSFT), a big tech stock that sparkled last year with a 53% gain, is down more than 40% since the Nasdaq Composite peaked in March 2000. That's 11 percentage points worse than the humdrum and oft-maligned ( FMAGX) Fidelity Magellan fund, the largest of the lot with some $80 billion in assets.

The bottom line is that it's OK to be upset that your 401(k) now feels like a 201(k), but it's not a smart move to give up on funds altogether.

Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to imcdonald@thestreet.com,
but he cannot give specific financial advice.